This blog aims to study the mechanics of business and occasionally find a gem of insight.

(Consult your financial adviser before making investment decisions. Following the advice here does not guarantee performance and there is a substantial risk of loss)

Monday, April 20, 2009

Quantifying The Value of Trust - Assigning a Value to the Intangible

I was recently having lunch with a colleague who was involved in the import / export business. He was describing how he was currently dealing with the shipment from overseas and the customs related to this transaction when we got to the topic of financing.

What had initially started off as a conversation about the mechanics of importing and financing (supply chains, letters of credit, customer relationships etc) eventually wandered into the realm of how to value trust.

It began with my colleague outlining the various incremental stages of an international supply chain relationship:

New relationship. You don't know the supplier and the supplier doesn't know you. Although you both require each others services, you need to be sure that the other party won't default on their side of the transaction. You bring in banks (or government trade institutions) in order to secure financing and guarantees with an irrevocable letter of credit for the payables (supplier / exporter) and the appropriate shipping documentation for the receivables such as the bill of lading (importer).

Mature relationship. You have conducted business with the supplier previously and are more familiar with the terms of delivery and credit. While perhaps there are not as many requirements necessary for insurance type guarantees against default, there is still the need for appropriate financial transactions. The banks are still involved in currency conversions and transactions.

Intimate relationship. Payment and shipping terms can be adjusted according to needs of both parties with minimal (if any) intervention by intermediaries. This improves cash flow as well as just-in-time / economies of scale related inventory needs and has a built in stress tolerance against default.

While this progression of trust and relationships may seem quite obvious, what surfaces upon further analysis is an ability to quantify the value of trust at each stage.

For instance, between stages 1 and 2, the monetary value of the improved relationship and trust can be approximated by the reduction of cost associated with no longer requiring intermediaries such as banks to provide services to insure and guarantee the transaction. This can become quite sizable as the fees associated with these services are not insignificant. You are essentially paying banks to manage risk for you.

Between stages 2 and 3, the monetary value is a bit less obvious, but still applicable. For instance, financing costs with deferring payment can be calculated as the marginal cost of capital required to reorganize the payment schedule. The cost of financing to improve cash flow is also not marginal relative to the overall costs of the transaction (usually a sizable percentage).

In this way, it is easier to put a price tag on something intangible by looking at the opportunity cost of the alternatives and the financial outlays associated with each. It also quantifies the investment in your relationship with suppliers (or customers) to see what the hidden costs were to arrive at these more optimal arrangements.